Here's How Your Social Security Benefits Are Calculated

Ever wonder where the benefit amounts listed on your Social Security statement come from? Understanding how your Social Security benefits are determined will help you understand how to maximize said benefits.

Qualifying for Social Security benefits

In order to receive any Social Security retirement benefits at all, you'll have to accrue at least 40 "credits." You get credits by earning wages from a job. In 2017, it takes $1,300 in earnings to get you one credit, and you can add up to four credits per year to your record. Thus you'll need to work at least 10 years to qualify for Social Security benefits (10 years x 4 credit per year = 40 credits).

Note that these are the rules for retirement benefits; the number of credits it takes to qualify for disability benefits will depend on your age at the time you become disabled, and it can range from six to 40 credits.

Your earnings history

Your Social Security benefits are based on your income during your 35 highest-earning years. Because the value of the dollar changes over time, the Social Security Administration uses an indexing factor to convert earnings from past years into the equivalent of today's wages. That puts everyone on a level playing field no matter how long ago they first started working. Once your earnings from those top 35 years are indexed, they're averaged out and then divided by 12 to produce your average indexed monthly earnings (AIME). If your work history is shorter than 35 years, the Social Security Administration will use zeros for the missing years -- which can drag down your average significantly, resulting in a smaller monthly benefit.

From earnings to benefits

Once they've worked out your AIME for your 35 highest-earning years, the folks at the Social Security Administration apply a formula to figure out how much you're owed in benefits. The formula changes from year to year, but for 2017 it works like this:

  • The first $885 of your average indexed monthly earnings is multiplied by 90%. Assuming your AIME is $885 or higher, the result would be $796.50.
  • The amount of your AIME that's greater than $885 and equal to or less than $5,336 is multiplied by 32%. If your AIME is at least $5,336, the result of this calculation would be $1,424.32.
  • The amount of your AIME that's above $5,336 is multiplied by 15%.
  • Finally, all three of these results are added together to produce your base benefit amount, which is the amount you'd receive if you claimed your benefits at full retirement age.

Claiming Social Security before full retirement age results in a penalty to your benefits; claiming your benefits after full retirement age earns you delayed-retirement credits that increase your benefit checks.

How to increase your Social Security benefits

As you can see, increasing your earnings is the most effective way to increase your benefits. At the very least, you'll want to accrue 35 years' worth of earnings before you retire so that you won't have any zero-income years to drag down your AIME. Also remember that the higher your income, the greater your benefit (up to a cap of $127,200, beyond which any additional earnings have no effect on your benefit). So if you're near the end of your career and you're earning far more than you did a couple of decades ago, you might consider working for a couple more years to boost your AIME.

It's also best (for most, but not all retirees) to wait at least until full retirement age to claim your Social Security benefits. If you want to maximize the size of your benefit checks, wait until age 70 to claim them; that will get you the largest possible delayed-retirement bonus. Delayed-retirement credits stop accruing after age 70, so there's no point in waiting longer than that.

Don't forget that Social Security's rules and formulas can change. Given that Social Security is projected to run out of surplus funds by 2034, it's likely that there will be changes to how Social Security benefits are calculated in the next couple of decades. That means you can't rely on having the benefits that your Social Security statement promises, especially if you're many years from your planned retirement date. You'd be wise to work hard at funding your retirement savings accounts so that even if your Social Security benefits don't meet your expectations, you'll still have enough income to enjoy your golden years.

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